Adjustable Rate Mortgages - Questions Answered
Following are things to consider if you think an ARM is the right choice for you.
- You will have the advantage of a lower payment at the beginning of the loan. But remember, when and if that rate increases, you could have higher payments in the future. It's a trade-off. Will that higher payment still work with your income? You get a lower rate in the beginning with an ARM in exchange for assuming more risk later.
- An ARM could be a good choice if your income is likely to increase in the future and/or if you plan to be in your home for less than six years. Why six years? Because there are limits to how much your rate will increase at any given adjustment, and your payment won’t usually jump too high with that initial adjustment. Even with a three year, you would be moved before that second adjustment takes place.
How does an ARM work?
There is an adjustment period – That’s where the “A” in ARM comes in. With most ARMs, the interest rate and monthly payment are fixed for an initial period such as three years, five years, seven years. After the initial fixed period, the interest rate can change every few years, depending on your specific ARM program. So, for example, a 3/1 mortgage is fixed for three years then adjusts annually.
An index rate dictates ARM interest rates changes. An index determines future rates based on actual market conditions at the time of or just ahead of your scheduled change. Financial institutions may use different indices, and in some cases, that varies by loan type. At MIT FCU, we use an index rate that is published weekly in the Wall Street Journal. If the index rate has increased (or decreased) when your mortgage rate is due to be reviewed for adjustment, your mortgage rate (and payment) will change.
Keep an eye on the margin. To determine the interest rate you will receive on an ARM, MIT FCU will add a pre-disclosed amount (referred to as the margin) to the index. If you are shopping around for ARMS, considering one lender’s margin against another lender’s margin can be more important than comparing the initial interest rate since it will tell you how much will be added to the specific index when it comes time for your rate to be reviewed and changed. In some cases, where the index is the same as the day you got your mortgage, you may have no change at all.
Is there a limit to how much your rate can change?
An Interest-Rate Cap places a limit on the amount your interest rate can increase or decrease.
There are 2 types of caps:
1. "Periodic" or "adjustment" type caps limit the interest rate increase or decrease from one adjustment period to the next.
2. “Overall” or “lifetime” caps limit the interest rate increase over the life of the loan.
As an example, you may have caps of 2/6. This would mean your rate can’t increase more than 2% per adjustment, or more than 6% over the life of your loan.
Interest rate caps are critical to prevent dramatic increases or decreases in the rates. Although wouldn’t a huge decrease be a great thing? All of the ARMs offered by MIT FCU have both adjustment and lifetime caps. Please visit our mortgage page for full details.
Negative amortization happens when your monthly payment changes to an amount less than the amount required to pay interest due. If a loan has negative amortization, you could end up owing more than you originally borrowed, because that shortage to pay interest means the interest is being added to your outstanding balance. This is more frequently seen in high-risk lending. MIT FCU products do not carry negative amortization ever.
Please keep in mind, some lenders may require you to pay special fees or penalties if you pay off an ARM early. MIT FCU never charges a prepayment penalty.
Reach out to our Mortgage Team to help you with this important financial decision and figure out if an ARM is the right fit for you.
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